Stephen Bainbridge's Journal of Law, Religion, Politics, and Culture

02/16/2012

The STOCK Act will not make whistle blowing illegal

A friend sent along a link to an NRO article by two guys from the Competitive Enterprise Institute -- named John Berlau and David Bier -- in which they claim that the STOCK Act banning insider trading by members of Congress will also ban whistle blowing.

There are so many mistakes in this article that it's hard to know where to start or what order in which to take them up. (As you can see, they caught me on a bad day. But even on a good day we're so close to finally passing the STOCK Act that misinformation about the Act is going to light a very short fuse. And if the civility nannies have a problem with that, they can [colorful but highly uncivil suggestion deleted].)

First, it's critical for you to understand that there are two basic theories of insider trading liability. As the Supreme Court explained in US v. O'Hagan, 521 U.S. 642, 652 -53 (1997):

The two theories are complementary, each addressing efforts to capitalize on nonpublic information through the purchase or sale of securities. The classical theory targets a corporate insider's breach of duty to shareholders with whom the insider transacts; the misappropriation theory outlaws trading on the basis of nonpublic information by a corporate “outsider” in breach of a duty owed not to a trading party, but to the source of the information. The misappropriation theory is thus designed to “protec[t] the integrity of the securities markets against abuses by ‘outsiders' to a corporation who have access to confidential information that will affect th[e] corporation's security price when revealed, but who owe no fiduciary or other duty to that corporation's shareholders.”

The concern in whistle blowing cases, of course, is not the whistle blower will himself trade on the basis of material nonpublic information, but rather that someone to whom he discloses the information will do so. Berlau and Bier thus set up the following hypothetical:

You are a conscientious congressional staffer who still takes seriously the need to be a steward of taxpayers’ money. ... Suddenly, you hear about an outrageous earmark about to be slipped into the bill that would enrich a Fortune 500 company. You decide to alert a network of fiscal watchdogs you’ve met with over the years to wage an instant campaign against this piece of corporate welfare. ...

You sit back and think, “It is indeed possible that someone I send this to could buy stock in the company, or could short the company based on the coming outrage.” You stare at the computer screen wondering how virtually no one noticed how this law could have potentially criminalized an act of whistleblowing as abetting “insider trading.”

They thus claim that the STOCK Act bans whistle blowing. It's possible they could be more wrong, but it's hard to see how.

1. As currently drafted, the STOCK Act broadly bans insider trading by members of Congress, Congressional staffers, and other federal employees. As currently drafted, however, the STOCK Act is unnecessarily broad. As I demonstrated (conclusively, if I may so myself who shouldn't) in my article Insider Trading Inside the Beltway, insider trading and tipping by Congressional staffers and executive branch employees is already illegal under current law. It was only Members of Congress who fell through the cracks of current law. If whistle blowing constitutes an illegal tip, accordingly, it's illegal under current law. The STOCK Act thus doesn't change the liability exposure of Congressional staffer whistle blowers in a single iota.

Berlau and Bier's hysteria is thus wholly misplaced. But even if the STOCK Act did change the law applicable to staffers, it still wouldn't make whistle blowing illegal. You see, all the STOCK Act does is to extend current law to members of Congress etc. And there's no way whistle blowing is illegal under current law.

2. In insider trading jargon, disclosure to someone who uses the information to trade is known as "tipping." Under the classical theory of insider trading, it is clear beyond the shadow of a doubt that a tipper can only be held liable if he gets a personal benefit for making the tip. as the Supreme Court explained in Dirks v. SEC, 463 US 646, 661-63 (1983):

In determining whether a tippee is under an obligation to disclose or abstain, it thus is necessary to determine whether the insider's “tip” constituted a breach of the insider's fiduciary duty. All disclosures of confidential corporate information are not inconsistent with the duty insiders owe to shareholders. ... Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure. This standard was identified by the SEC itself in Cady, Roberts: a purpose of the securities laws was to eliminate “use of inside information for personal advantage.” Thus, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.

The Dirks case itself in fact involved whistle blowing, albeit in the corporate context. The Court held that the whistle blower got no personal benefit (Id. at 666-67):

It is clear that neither Secrist nor the other Equity Funding employees [i.e., the tippers] violated their Cady, Roberts duty to the corporation's shareholders by providing information to Dirks. The tippers received no monetary or personal benefit for revealing Equity Funding's secrets, nor was their purpose to make a gift of valuable information to Dirks. As the facts of this case clearly indicate, the tippers were motivated by a desire to expose the fraud. In the absence of a breach of duty to shareholders by the insiders, there was no derivative breach by Dirks [i.e., the tippee].

Berlau and Bier's claim -- based on a single 2003 law review article -- that "courts are split on whether a 'personal benefit' is even required for guilt" is thus obviously erroneous insofar as the classical theory is concerned.

3. To be sure, most (all?) Congressional staffer tipping would implicate the misappropriation theory (since they're unlikely to be insiders of the issuer about whom they tipped information). And it is true that some older district court opinions cast doubt on whether the Dirks personal benefit requirement applies to misappropriation theory.

BUT (and it's a big but) those cases were almost all district court opinions. The relevant passages of most are dicta rather than holding. They are all older cases. And they are clearly in the minority.

Most courts considering the issue have held that the personal benefit test does apply in misappropriation cases for policy reasons. The Eleventh Circuit noted in SEC v. Yun that attaching different requirements “constructs an arbitrary fence” between the two theories, while the harm to the securities market would be the same in both cases. Additionally, because insiders who tip are often misappropriating information as well, employing different tests for liability would, according to Yun, “essentially render Dirks a dead letter” by creating a loophole for the government to avoid the personal benefit test in many cases involving corporate insiders.

Law professor Donna Nagy likewise explains that (94 Iowa L. Rev. 1315, 1348 n.196): "courts generally apply Dirks' requirement of a personal benefit in misappropriation cases, notwithstanding that Dirks was a case under the classical theory." As support she cites the leading treatise Ralph C. Ferrara, Donna M. Nagy & Herbert Thomas, Ferrara on Insider Trading and the Wall 2-71 to -74 (2008).

4. It's probably not enough that the tipper think it is "possible that someone I send this to could buy stock in the company." In Elkind v. Liggett & Myers, Inc. 635 F.2d 156, 167 (2d Cir. 1980), the Court held that:

One who deliberately tips information which he knows to be material and non-public to an outsider who may reasonably be expected to use it to his advantage has the requisite scienter. ... One who intentionally places such ammunition in the hands of individuals able to use it to their advantage on the market has the requisite state of mind for liability under [sec.] 10(b) and Rule 10b-5.

Granted, the Second Circuit subsequently rejected the argument that "that tippers must specifically know that their breach of a fiduciary obligation in misappropriating information will lead to trading on the information." U.S. v. Libera, 989 F.2d 596, 600 (2d Cir. 1993). As Professor Donna Nagy has observed (59 Ohio St. L.J. 1223, 1263 n.199), however:

This aspect of Libera's holding certainly must be reevaluated in light of O'Hagan. If the tippers did not have any knowledge that the information conveyed would be used by the tippees for securities trading purposes, it is difficult to see how the tippers' breach of duty (in which the tippees are co-participants) can satisfy even the broadest interpretation of Section 10(b)' s “in connection with” nexus. And without a breach of duty on the part of the tipper “in connection with” a securities transaction, there is simply no basis for imposing Section 10(b) and Rule 10b-5 liability on either the tippers or the tippees.

On top of which, I don't see how Libera could ever have been squared with the scienter requirement under Rule 10b-5.

5. In an especially egregious piece of fearmongering, Berlau and Bier claim that the SEC might extend Regulation FD to Congress, such that it will "require meetings and calls in which Congress members and staffers participate to be open to the public or not occur at all. The result would be less outflow of information from Congress and a less informed public." There is NOTHING in the STOCK Act that would require, encourage, or authorize the SEC to do so. Nada. Zilch. Zip. On top of which, Regulation FD was adopted precisely because the Dirks framework did not make selective disclosure by corporate insiders to analysts illegal. The SEC authority to adopt Reg FD thus does not depend on insider trading law. Accordingly, in the incredibly unlikely event that the SEC decides to extend Regulation FD to Congress, it could do so even if the STOCK Act never passes.

6. I admit that I've long suspected that the SEC thinks there is an invisible footnote to the First Amendment that exempts it from the prohibition on interfering with the right of free speech. After all, what is disclosure regulation if not a regulation of speech? What is the rule on shareholder proposals, if not forced speech? But surely not even the SEC would argue that it can police political speech in the same manner it polices corporate speech. And even if the SEC did so, have Berlau and Bier never heard of the courts? I'm prepared to wager the best bottle of wine in my cellar (probably the 1982 Chateau Gruaud Larose or the 1982 Chateau Montrose) that if the SEC tried to apply the insider trading laws to whistle blowing or Reg FD to Congress that the courts would invalidate in a heartbeat.

To SUM up: I don't know why Berlau and Bier decided to peddle this load of codswallop, but a load of codswallop it is. The STOCK Act doesn't change the law applicable to Congressional staffers. Under current law, whistle blowing is not illegal tipping. Ergo, whistle blowing by staffers will still be perfectly legal once Congress passes the STOCK Act.